Markets & Interest Rates

Financial Markets All entities need finance to run business Financial markets - Platform that brings together entities with surplus money and those that need money Different types – Assets backing, Risk, Return, Duration, etc.

Financial System Existence of a well organized financial system Promotes the well being and standard of living of the people of a country Money and monetary assets Mobilize the saving Promotes investment

Financial System Financial System of any country consists of financial markets, financial intermediation and financial instruments or financial products Suppliers of funds (Mainly households) Flow of financial services Incomes, and financial claims Seekers of funds (Mainly business firms and government) Flow of funds (savings)

Indian Financial System Non- Organized Organized Money lenders Local bankers Traders Landlords Pawn brokers Chit Funds Regulators Financial Institutions Financial Markets Financial services

Financial System Savers Lenders Households Foreign Sectors Investors Borrowers Corporate Sector Govt.Sector Un-organized Sector Economy Interrelation--Financial system & Economy

Organized Indian Financial System Money Market Instrument Capital Market Instrument Forex Market Capital Market Money Market Credit Market Primary Market Financial Instruments Financial Markets Financial Intermediaries Secondary Market Regulators

Financial Markets Mechanism which allows people to trade Affected by forces of supply and demand Process used In Finance, Financial markets facilitates

Why Capital Markets Exist Capital markets facilitate the transfer of capital ( i.e. financial) assets from one owner to another. They provide liquidity. –Liquidity refers to how easily an asset can be transferred without loss of value. A side benefit of capital markets is that the transaction price provides a measure of the value of the asset.

Role of Capital Markets Mobilization of Savings & acceleration of Capital Formation Promotion of Industrial Growth Raising of long term Capital Ready & Continuous Markets Proper Channelisation of Funds Provision of a variety of Services

Indian Capital Market MarketInstrumentsIntermediaries PrimarySecondary EquityDebtHybrid Regulator Brokers Investment Bankers Stock Exchanges Underwriters SEBI Players CorporateIntermediaries Banks/FIFDI /FII Individual

Capital Market Instruments ADR / GDR Equity Debt Equity Shares Preference Shares Debentures Zero coupon bonds Deep Discount Bonds Hybrid

Money Market Market for short-term money and financial assets that are near substitutes for money. Short-Term means generally period upto one year and near substitutes to money is used to denote any financial asset which can be quickly converted into money with minimum transaction cost

Money Market It is a place for Large Institutions and government to manage their short-term cash needs It is a subsection of the Fixed Income Market It specializes in very short-term debt securities They are also called as Cash Investments

Defects of Money Market Lack of Integration Lack of Rational Interest Rates structure Absence of an organized bill market Shortage of funds in the Money Market Seasonal Stringency of funds and fluctuations in Interest rates Inadequate banking facilities

Money Market Instruments Treasury Bills Commercial Paper Certificate of Deposit Money Market Mutual Funds Repo Market

SegmentIssuerInstruments Governm ent Central Government Zero Coupon Bonds, Coupon Bearing Bonds, Capital Index Bonds, Treasury Bills. Public Sector Government Agencies / Statutory Bodies Govt. Guaranteed Bonds, Debentures Public Sector Units PSU Bonds, Debenture, Commercial Paper PrivateCorporate Debentures, Bonds, Commercial Paper, Floating Rate Bonds, Zero Coupon Bonds, Inter-Corporate Deposits BanksCertificate of Deposits, Bonds Financial Institutions Certificate of Deposits, Bonds

Financial Institutions Financial intermediaries Commercial banks Investment banks Mutual funds Insurance/Pension funds Direct Transfers Company / Government as borrower and Saving households

Cost of Money There is no free lunch There is cost to money Stocks – Dividend Debt – Interest Factors affecting cost of money –Return –Risk –Time duration –Inflation

INTEREST RATE A FUNCTION OF SUPPLY&DEMAND INTEREST RATE – ALLOCATION OF CAPITAL COMPETITION FOR CAPITAL ALLOCATION INTEREST RATE – TOOL FOR INVESTMENT DECISIONS

Illustration Market A vs Market B Cost of capital10%12% Demand for fund deccreases – Interest rates will decline Supply tightened due to monetary policy – Interest rates will increase Markets A & B are interdependent Risk premium = 12% - 10% = 2%. If demand for fund decreases, supply will shift to Market B as risk premium is 4 % (12% - 8%) Market A supply will decrease which will increase interest rate again before balancing at 2% risk Premium

INTEREST RATE DETERMINANTS Expected rate of return = Real risk free rate + Inflation premium + Default risk premium + Liquidity premium + Maturity risk premium The Nominal risk free rate of interest = Real risk free rate + IP

FACTORS AFFECTING DEMAND/SUPPLY Monetary Policy Fiscal Policy Foreign Trade Balance Business Activity

INTEREST RATES VS STOCK PRICES INTEREST RATES AFFECT PROFITABILITY INTEREST RATES ALTERS ECONOMIC ACTVITIY CHOICE OF BOND VS STOCK BASED ON INTEREST RATES

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